Gold Outlook 2011: Irreversible Upward Pressures and the China Effect

As presented by Nick Barisheff, January 6, 2011 at the Empire Club 17th Annual Investment Outlook Luncheon

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Good afternoon. It is a pleasure to return to the Empire Club to discuss the outlook for gold and precious metals in 2011. I know this may appear to some to be an enviable job—getting to speak about the one asset class that seems to continually out-perform all others year after year—but it is a double edged sword.

I’ve struggled to find an appropriate simile. The best I can come up with is that speaking about gold is like one of those good news bad news jokes, you know the ones—your doctor phoned with some good news and some bad news. The good news is they will be naming a new incurable disease after you.

The good news is that gold is rising in value; the bad news is—well nearly everything else about the economy.

This year we travelled to the Middle East, the Far East and South and Central America to discuss gold. The different mindsets about gold we encountered there surprised all of us. Most people in these countries see gold as the protector of wealth. In the West, we view gold as a commodity for speculation.

Western economists treat the act of buying gold as an admission of defeat and their attempts at disparaging gold’s steady rise became even more tenuous than ever this past year. Some of these disparaging opinions include:

• “Financial tightening will cause commodity prices to fall.”
• “Gold is in a bubble.”
• “The gold stocks haven’t confirmed the gold bull.”
• Perhaps most desperate of all—“The economy is on the road to recovery.”

Despite these protests, gold had another remarkable year. It was up 25 percent in 2010, which marked its tenth straight annual gain.

Although we are speaking about gold today, I would be remiss in ignoring silver’s performance. Silver is up 78 percent in 2010 as it is, like gold, beginning to assume its role as a monetary metal. Platinum was also up 17 percent.

When we look at a ten year chart of the US and Canadian dollars, the Euro, the British Pound and the Yuan, we see that these five major currencies have lost between 70 to 80 percent of their purchasing power against gold over this 10 year period. In truth, gold is not rising, currencies are falling in value and gold can therefore rise as far as currencies can fall.

Three Short to Mid-Term Trends

I’d like to pick up where we left off last year with a review of three dominant medium term trends that put upward pressure on the price of gold in 2010 and will likely continue to in 2011. Then I’d like to look briefly at three longer term, irreversible trends that will put downward pressure on currencies resulting in upward pressure on gold for decades.

First, the three dominant mid-term trends we discussed last year.

These are:

1. Central bank buying
2. Movement away from the US dollar
3. China

Central Bank Buying

In 2009, for the first time in 20 years, monetary gold, or central bank and investment buying, outpaced gold buying for industrial or jewellery purposes. In 2010 China, Iran, Russia and India’s central banks were all significant buyers as they moved cash reserves to gold.

In Q3 of 2010, Russian central bank gold holdings rose seven percent to 756 tonnes. In 2010, the Russian Central Bank bought two thirds of its own gold production.

In December we learned that China had imported 209.7 metric tonnes of gold in the first 10 months of the year. This was a 500 percent increase over the same period of 2009 and on top of their world leading domestic gold production.

By the third quarter, India’s gold imports, both commercial and private, for the year were 624 tonnes, putting them 100 tonnes above the previous year’s total of 595 tonnes.  Fourth quarter purchases could put India’s annual total over 750 tonnes.

China and Russia need to acquire gold to bring their gold reserve ratio to outstanding currency closer to Western central banks. Russia needs to acquire at least 1000 tonnes and China at least 3000 tonnes to remain on parity with the US. Chinese officials have stated publicly that China would like to acquire at least 6000 tonnes.  Unofficially they have stated targets as high as 10,000 tonnes.

Movement Away from US Dollar

Last year we quoted a November 2009 story written by veteran journalist Robert Fisk claiming Russia and China along with France, were working on an agreement to trade oil with Arab states using currencies other than the US dollar. As expected, central bankers fervently denied these rumours. The US dollar has since 1973 been the only currency that oil could be traded in. This is the only reason the US has been able to amass nearly $14 trillion in debt. Loss of the petrodollar’s hegemony would have a devastating effect on the US as this is essentially the only reason foreign countries in the past needed to hold US dollars.

On November 24, 2010, China and Russia officially ``quit the dollar`` and agreed to use each other’s currencies for bilateral trade—including oil. Official trading on Moscow’s MICEX Index began December 15th, 2010.
In 2009, Robert B. Zoellick, made his well-publicized comment that, the US would be "... mistaken to take for granted the dollar's place as the world's predominant reserve currency.” And that, “... looking forward, there will increasingly be other options to the dollar." In 2010 he continued hinting at a new reserve currency made up of five currencies with gold as the “reference point.” He also called for a new Bretton Woods agreement this year.  Mr. Zoellick is no lunatic goldbug. He’s the President of the World Bank.

China

Last month, I was a speaker and panellist at the China Gold and Precious Metals Summit in Shanghai. I can confirm that Chinese buying, both official and public, is a major trend that is not only well in place, but may be the single most important influence on the price of gold in 2011. As I said, the Chinese see gold quite differently from the way we see it. If we are to understand gold’s price direction in 2011 and beyond I believe it is essential to understand the “mindset” the Chinese have built around gold.

Economic Mindsets and Gold

Although the forming of economic mindsets is a complex topic, I’d like to simplify how major financial mindsets are created in one sentence. What our government, our banks and financial media tell us about money is what most of us will accept as our financial mindset or financial reality. If anyone doubts the power of government economic policy to shape mass economic reality, just look at how we have changed our attitudes towards debt, saving and economic value over the past 40 years. Our current debt based mindset began to form the day the US dollar, the worlds reserve currency, was removed from its final international peg with gold in 1971.

Different Attitudes about Gold

Although the West shares many common economic principles with the East, as the capitalist banking systems are similar, there is one area where there is a clear distinction—this is how Easterners view the role of gold as money.

Western governments fear gold. It restricts their ability to create currency.
In the West, governments borrow and encourage their constituents to follow their example. Banks encourage us to borrow for everything from vacations to widescreen televisions made in China. They tell us we are “stimulating” the economy through consumption. Generally speaking, the investing public in the West sees gold as a wealth gaining asset to be traded like stocks and bonds. This is why Westerners are constantly fretting about the price of gold in currency terms.

The Chinese government, on the other hand, respects gold. This is evident by the laws they have passed to facilitate mining and private gold ownership. China currently leads the world in gold production.

The government encourages the public to put five percent of their savings—yes they encourage savings—into gold. This is significant because the Chinese can save up to 40 percent of their annual salary. In the West, most middle class families are lucky to break even. The Chinese see gold as a wealth preserving asset that will weather all seasons. This is the difference that I believe anyone who wishes to fully understand gold’s rising price must comprehend. Inhabitants of older countries, who have lived through the destruction of an inflation fuelled currency crisis, do not need to be reminded that gold is the most effective hedge against inflation and a currency crisis.